A different kind of oil shock

The inexorable rise in crude oil prices has led to the search for parallels in the past and more and more people are harking back to the 1970s, when shocks from the Arab-Israeli war in 1973 and the overthrow of the Shah of Iran in 1979 led to sharp spikes in the price of oil. The deadly mixture of inflation and low growth seen at the time led to the coining of a new word: stagflation.

Here are the numbers. During the second oil shock, the price of Brent crude more than doubled from $14 a barrel in 1978 to $31.60 a barrel the following year. Thereafter, it moved up to $36.80 in 1980 and to $35.93 in 1981 and it wasn’t till 1986 that the price per barrel went below $20. The impact on growth was very clear: International Monetary Fund (IMF) data, cited by economist Angus Maddison, show that world GDP growth, which was a high 4.5% in 1978, fell to 3.7% in 1979 and to 2.5% in the following year. Thereafter, the growth rate continued to slide, reaching a nadir of 0.6% in 1982 before starting to move up again.

If the 1970s are a guide, the numbers seem to be telling us two things. One, oil prices are not going to come down in a hurry—they remained high for several years in the 1970s and 1980s. And two, growth has to fall to very low levels to force oil prices down. Economic growth has been very high in the last four years with world GDP growth at 4.9% in 2004, 4.4% in 2005, 5% in 2006 and 4.9% in 2007, according to IMF data. Going by past experience, therefore, growth will have to fall very substantially from current levels in order to make a difference to oilprices.

What was the impact of the oil price shocks in India? GDP growth fell from 5.5% in 1978-79 to -5.2% the following year, but bounced back to 7.2% in 1980-81. But the sharp fall in GDP had much to do with low agricultural production in 1978-79. Industrial production growth, a better measure, fell 2.9% in 1978-79, was 1.9% in 1980-81 before going up to 8.9%. The sharp fall in growth was accompanied by very high inflation. The wholesale price index shot up by 17.1% in 1979-80 and by 18.2% in 1980-81 before falling to 9.3% in 1981-82 and further to 4.9% in 1982-83. Of course, the Indian economy today is very different from the economy of the late 1970s or early 1980s.

That is true of inflation as well. Today’s global oil price rise is very different from that of the seventies. At that time it was disruptions in supply that caused the oil price hike. Today, on the contrary, it’s higher demand that’s thereason.

Moreover, unlike in the eighties, most of the incremental demand for oil now comes from emerging markets. Oil giant BP’s recent review of global energy consumption points out that China accounted for half of global energy consumption growth in 2007, with India coming in third after the US. The review says that the rise in crude oil prices for the sixth consecutive year in 2007 is the longest unbroken period of growth in prices since 1861, when their data set first started. That record undoubtedly has a lot to do with the fact that 2007 was the fifth consecutive year of above- average energy consumption.

The other thing that’s very different from the 1970s is the behaviour of the US dollar. During the 1970s, the dollar was appreciating and the nominal broad dollar index, which was at 34.65 in January 1979, had moved up to 68.20 by June 1985. This time, however, the dollar has been depreciating and the chart alongside shows the fall in the dollar index. That gives ammunition to those who argue that it is low interest rates in the US that has led to dollar depreciation, which in turn is responsible for the hike in crude oil prices this time.

The rise in oil prices is not just the result of a falling dollar, although it’s very likely that the depreciation has added to the upward pressure on crude. But what seems to be clear is that although today’s rise in crude oil prices may have certain superficial similarities to the oil shock in the 1970s, it is actually a very different animal.